Monthly Archives: November 2011

Burning the (wrong) bondholders

One of the great Christmas pleasures is watching Wallace and Gromit. For me their masterpiece of comedy noir is ‘the wrong trousers’, in which an unfortunate (but of course arising from a well-intentioned) wardrobe malfunction leads to Wallace being in effect kidnapped by his TechnoTrousers. A series of Claymation japes and high jinks ensues, but all is put right at the end.

Something similar seems to have happened Michael Noonan.  A well-intentioned effort to make a solid bank has taken him down a strange path. The proposal to impose up to 100% losses on the subordinated bondholders of Bank of Ireland arises from a good intention – that Bank be well capitalized, and that to do this it raises €4.2b by the end of the year. It is at present, despite a range of actions, some €350m short. So, the government is proposing to use its powers to in effect ‘burn’ subordinated bondholders, generating in that way the needed capital. Now, I have long argued that it was an immoral, unnecessary and needless waste of state funds to have kept ANY subordinated bondholders in play in the banks while the state invested taxpayers money. We invested €3.5b in 2008-9, and took up rights issues of €2b in total. The result is that the state now has approx. 15% of a bank plus a remaining high(ish) yielding preference share. At the time of the crisis, as show in appendix A, p 150, Bank of Ireland had €4.6b of dated subordinated debt, which was guaranteed and thus was at that stage unable to be deployed fully towards losses. Now, with the bank in essence almost out of the critical phase of the crisis this arises, which while perhaps welcome needs to be wondered at. It needs to be wondered at in the context of ….Anglo.

Bank of Ireland is, in my view, at first approximation, the only Irish bank that can exist outside longterm state control. And no, I don’t have shares in it.  AIB has collapsed into the state and will require massive and on-going restructuring both of its finances and its operations if it is ever to be refloated or sold off. And then there is Irish Bank Resolution Corporation, the banks formally known as Anglo ad Irish Nationwide.

Faced with a choice the government decided to spend €1b of taxpayer funds on unguaranteed unsecured bonds of a dead bank. Anglo is dead, but zombie like will not stop moving and consuming.  Putting money into Anglo is, as Constantin Gurdgiv described it “like gold plating a yugo and sinking it somewhere”.  Putting money into Bank of Ireland, with the state taking a modest increase in its share for the sake of (hopefully) completing the rehabilitation of a working bank and one on which the state might eventually even get some return.

Government is about choices; the monies sunk into the banks are sunk, but the ongoing decisions about how to spend scarce resources on banks should revolve around the marginal benefit. One the one hand, the whiling vortex of money that is Anglo/INBS, on the other a quasi-viable bank. I know which I would choose.

Solvency the European issue

This is a slightly extended version of a oped published in the Irish examiner : 

With every day that passes the fault lines within Europe become clearer and wider. Germany’s Chancellor now appears to be increasingly isolated, reminiscent of the Irish mother looking at children walking up and down the road saying “sure they’re all out of step apart from my Johnny” in relation to how the crisis should be resolved.There is a problem in my opinion of misdiagnosis of crisis. Proposals have been put forward on the assumption that what European sovereigns are facing is a crisis of liquidity. It is reminiscent of the Irish government’s responses in 2008 and early 2009. Then we will recall that the assumption was that Irish banks were suffering  from a lack of liquidity when it was eminently clear that whatever suffering from a lack of solvency. In the case of several European countries, Greece for most but perhaps also Ireland, solvency not liquidity issue. The European political system, led up to now by Franco German axis which as France comes under pressure looks like splintering, is acting like the black night in the Monty Python skit, crying out as  Successive governments and societies are amputated “it’s only a flesh wound”.

The European central bank has the tools available to it, but is also debatable as to whether these tools are the ones that should be used to end the crisis. At the moment what we have is a veto by the troika this you’re in each country on government spending. Handing over that veto, even if only in a flexible manner, the European central bank does not make this an enormous improvement, and remains a deeply undemocratic as the present situation. The issuance of Eurobonds, or other forms of collective fiscal funding ignores both the existing levels of debt and again runs the risk of handing over the power of the purse to an undemocratic organisation. The history of political economy is that the power to raise and spend taxes is inextricably linked with the growth of the modern democratic state. If Europe wishes to move towards further fiscal integration this can only happen along with further deepening of democratic control over this fiscal centralisation.

At the crux of the present impasse is a cultural problem. In my opinion the crux of the present problem is cultural. We all recall in Ireland the plaintive cries that “Ireland is that Iceland”. That is very true, and more’s the pity when you consider the relative performance of Ireland and Iceland over the last two years. But if Ireland is not Iceland, then Europe is not Germany. The E in the ECB stands for European. It is as foolish to expect Greeks, Spaniards, or even Dutch, to become German as it is to expect Germans to overcome decades of cultural antipathy towards (the fear of) inflation. The institutions in Europe are curious bunch. Most national or supranational institutions are an outgrowth of society. The European institutions are a deliberate attempt by societies over time to produce institutions were no common cultural norms or commonalities exist. This was not make them any more or less valid, it just means they are inherently top-down rather than bottom-up. Other countries which we hailed as being rather monolithic may not be as such. People consider the United States to be a fairly monolithic whole while it is generally accepted that the USA is a optimum currency region, but in fact this may not be the case. Psychological and anthropological research shows that the degree of intra state differences in attitudes towards individualisty,, towards teh role of the individual and society, towards the whole series of cultural indicators are just as large as those between various parts of the European Union. Vast economic diffeerences persist between parts of the USA, yet the currency remains intact with even defaults of large cities and states not seeming to threaten the whole. The United States has however a very powerful federal government, which is easy to forget emerged out of the Crucible of an extremely bloody civil war. The experience of the United States in forming political economic institutions such as the Federal reserve board shows that nationbuilding takes a long time, is not easily achieved, and takes political will. At the moment the political will to even see that the problem is systemic, is not one of liquidity, will require give-and-take on both sides of the German/rest of Europe divide, is missing.

Planning for the post euro Irish economy….

This is an extended version of an opinion piece published in the Irish Examiner 12 November 2011

With every week that passes it is becoming unfortunately clear that under present arrangements the euro cannot continue. We have seen political dithering of the worst kind, persistently, with the resulting vacuum in terms of policy being taken up by the European Central bank. Although one can criticize the ECB for many of its activities (not least the bewildering refusal to contemplate the other side of the fence in relation to Anglo) is to its credit that has at least stepped into the breach. However of all of the European institutions it is probably the least democratic, as independent central banks have to be. Every ECB action, no matter how well-meaning, in the absence of political and therefore democratic-based approaches further undermines the democratic legitimacy of the euro. Trust in the ECB has and will continue to dwindle.  In any case ECB intervention in bond markets has at best only a temporary effect, and it is ultimately up to governments at national and European level to implement policies that restore fiscal discipline. The academic research on bond yields is thus while in the short term like any asset they can be moved by speculative positions in the medium and long-term contract very well against economic fundamentals.

The action this week has focused on Italy. Heretofore the countries that have found themselves locked out of the financing markets have been ones, which were sustainable, non-systemic, and manageable.  Italy is simultaneously too big to fail and too big to save.   Italian Public debt is the third-largest, in absolute terms, in the world:  it has to refinance  €200 billion in the next year: GDP is the eighth largest in the world. And yet this week we have seen that Italy is, in effect,  locked out of the bond markets, at least anything approaching sensible rates.

We also see this week that, despite there being no formal mechanism for doing so, it has been suggested by leading European officials and politicians that countries can exit the Eurozone. It is highly probable that an exit by any country would lead to a cascade, resulting in the effective breakup of the euro. What then for Ireland?

The first thing that must be said is that hopefully somewhere in government there is a plan. Governments should plan for all eventualities. Planning to deal with an eventuality is not the same as wishing for same; failure to plan could be catastrophic. The historical evidence is not good that there is a coherent,  competent analytically sound plan cooking in the Dept of Finance

Secondly in the event of the euro breaking up, which may be as a result of the Cascade outlined above or perhaps due to the German political system not being able to persuade itself or its constituents of the need for Germany to accept that it is going to have to foot the bill, there will be significant winners and losers in Ireland. In a first decision that would have been made by the government would be whether or not in the event they would allow a freely floating currency, which would almost certainly depreciate significantly,  or whether they would put in place some form of managed float.  While depreciation would be attractive, in that it would be a boost to exports and therefore assist in putting the country back on a growth path it would also result in imports becoming more expensive. A third of our imports come from the United Kingdom, and in all likelihood the new Irish pound would be weaker than sterling. It was also likely to be weaker than the dollar, which given our extreme dependence on imported  oil would result in significant increases in the domestic price of petroleum based products. All of these would rise in price, importing inflation and penalising businesses and consumers.

We will also have to very quickly move to achieving a primary surplus. The primary surplus instead of a primary deficit in government finances would be necessary in order to pay down the accumulated national debt. When we consider the pain that we are going through in order to reduce the deficit to 3% over four years is hard to imagine the wrenching dislocation that would be required to achieve a primary surplus over a couple of years.  Yet that would be what would be required. We would have  to offer significantly higher rates on our debt to potential investors than is the case even know, not least because they would almost certainly be facing into a much more inflationary environment. Bond yields (see here and here for example) Are in large part driven by fundamental economic factors.

Another issue where there would be  mostly losers, would be  around external euro denominated liabilities.  External in this context means outside of Ireland. Mortgages, bank loans, any liabilities within Ireland would be converted to the new pound. It is the liabilities in euros outside Ireland that would be messy. The most likely option would be that these would be dominated into the currency of the country where they are located. Thus a loan taken out in Germany would be converted into Deutschmarks, which would result in a very significant increase in in these liabilities. conversely for multinationals with money on deposit in Ireland, and this amounts to billions of euros, any hint that these would be likely to be converted into a weaker currency would result in their being withdrawn. This in turn would exacerbate the existing credit crunch. The only feasible solution would be harsh exchange controls and a degree of financial repression for a time.

A possible area of concern is around banks dependence on ECB funds, which although declining, is still very high. Absent the ECB the central bank of Ireland would have to step into the liquidity breach, further exacerbating inflationary fears. On the positive side it would be much easier to restructure the Anglo promissory notes.

It is debatable whether or not Ireland should have joined the euro. At the time I was in favour, more from political economy perspective than a pure economics perspective. I felt at the time that on balance European  politicians were more likely to behave in an economically sensible manner than Irish politicians, and that the requirement as part of a monetary union from fiscal discipline would be useful for Ireland. Unfortunately this faith was misplaced on both sides.

Why the ECB are being unreasonable on bonds

This is an expanded version of a opinion piece published in the Irish examiner 5-November 2011:

This weekend the kilkenomics festival runs for the second time in Kilkenny. It’s a mixture of comedy and economics. To the casual onlooker it might be difficult to distinguish between when this festival stops and the normal run of Irish economic policy-making begins. It must be a comedy when a bankrupt country pays €700 million that it doesn’t have to, and misplaces  €3.6 billion in its national accounts. If it isn’t a comedy then it must be a tragedy.

Without a shadow of a doubt the most tragicomic element of this week was the payment by Anglo Irish bank (which of course has no money other than that which we the taxpayer provide) of $1 billion, over €700 million. This bond was unsecured, relying in other words upon the solvency and good faith and credit of Anglo Irish bank; it was also unguaranteed, in that it was not covered by the disastrous government guarantee of banking liabilities in 2008. Although technically not insolvent, because of the promissory notes which will cost the Irish taxpayer upwards of €80 billion with by the time all said and done, Anglo is economically bankrupt. The government faced a storm of protest, including what one can only imagine was a tongue in cheek contributyion on the inequity of such payments  by Fianna fail. It’s very clear looking in the round that the government, the taxpayer, payed  this private debt because they are being strong armed by the European central bank. From the European central banks perspective they see it as imperative that no senior bondholder in European banks should be forced take a loss. They have a point in this. In September Eurozone banks had approximately €10.7 trillion in deposits and €12.5 trillion in loans, plus some other assets. The difference deposits and other assets is accounted for by some €3 trillion in bonds issued by these banks. It is this €3 trillion that the ECB is concerned would be seen to be at risk were the miserable €700 million of Anglo Irish bonds not repaid. The argument, so the ECB say, is that if Anglo Irish bank do not repay their bond then markets will ask why any other bank would do so?. The consequence of this would be that sooner than later European banks would find themselves forced to either pay significantly more for bonds or reduced dependence on same. Either of these would result in a downgrading of euro area economic prospects, via more expensive bank credit and a deleveraging, that is to say a reduction in supply of credit.

The last thing that the European economy needs is a further blow to its economy. Eurozone growth prospects are low, with the OECD forecasting only a 0.3% growth;  industrial manufacturing based on purchasing managers surveys is in decline; unemployment is over 10%. Already the requirement to increase their capital ratios to 9%, agreed as part of the latest final solution to the twin bank-greek crises, is likely to result in some deleveraging. Indications are that the banks will not raise additional funds to strengthen their capital base but will instead adjust their assets, that is to say deleverage. So, the ECB, from a Eurozone perspective,  are doing the right thing in insisting that the Anglo bond be repaid.

The difficulty is that this Anglo bond is coming out of state funds. Anglo has been recapitalised multiple times, the only money of houses taxpayers money. From the Irish perspective it is both odious and irksome that not only are the Irish taxpayer is expected to be the ultimate prop for the Eurozone bank fund market  but they are getting very little back from the ECB in return. Irish banks remain critically dependent for liquidity on the ECB, but this liquidity is only advanced on a series of rolling short-term sales and repurchases. The ECB, quite bizarrely, has set its face against the provision of a structured medium-term liquidity provision. It is hard not to see this as simply a desire on the part of the ECB to keep the Irish government in line, via a threat, quite unrealisable in fact, that deviating from the ECB line of no bondholder being burned will result in the withdrawal of liquidity and the crashing of the Irish banking and financial system. The government claim that keeping the ECB ‘onside’ will allow them to negotiate with the Troika on the cost of the promissory notes, but this negotiation will be conducted, in part by the NTMA/Dept of Finance, who somehow mislaid 3.6b, a bookkeeping error so gargantuan as to hardly inspire confidence in their ability to deal with complex and large sums.

All this is against the backdrop of an Irish economy which, although anaemic halting and critically dependent on a small group of exporters, is beginning to show signs of stabilisation. We appear to have reached close to the bottom of the economic cycle, and although we will probably bumps along the bottom for quite some time we at least can begin to see a clear path. A functioning Irish banking system could only help, particularly if that banking system was adequately capitalised, appropriately supervised, structured in such a way that credit would float productive rather than bubble lending, friendly to small and medium enterprises, a true utility banking system. We will be a long time waiting for that.